Review: Macroeconomic Policies

(NOTE: when I use the term "policies", I always mean "government
policies").

What is the role of the government in a market economy? In a
market economy (capitalist economy) the government has a limited
role, but some people believe that the government should try to help
the economy maintain full employment and low inflation. We have
discussed in the 5 Es lesson that unemployment results in greater
scarcity since some resources are not being used so less will be
produced. Government policies may be able to help the economy achieve
full employment and therefore reduce scarcity.

Stabilization Policies

Definition: government policies design to reduce UE
and/or inflation All the policies discussed here can be classified
as stabilization policies.

There are two major types of stabilization policies:

demand-management policies

supply-side policies

Demand-Management Policies

Definition: Policies design to shift the AD curve in
order to reduce unemployment or to reduce inflation.

Tools -- Some of the determinants of AD can be manipulated by
the government to achieve these goals.

There are two types of demand-management policies depending
upon WHO conducts the policy:

fiscal policy is undertaken by the president and the
congress, and

monetary policy is undertaken by the Federal Reserve Board
(often called the "fed").

Fiscal Policy

Definition:
discretionary
fiscal policy

Deliberate
changes in taxes (tax rates) and government spending by
Congress to promote full-employment, price stability, and
economic growth.

Fiscal Policy
tools

a. government
purchases (spending)
b. taxes
c. both

Expansionary Fiscal
Policy

An increase
in government expenditures for goods and services,

a decrease
in taxes,

or some
combination of the two

for the
purpose of increasing aggregate demand and expanding real
output

this
will reduce UE

The goal of expansionary fiscal policy is to reduce
unemployment. Therefore the tools would be an increase in
government spending and/or a decrease in taxes. This would shift
the AD curve to the right increasing real GDP and decreasing
unemployment, but it may also cause some inflation.

Contractionary Fiscal
Policy

A
decrease in government expenditures for goods and services,

an
increase in net taxes,

or some
combination of the two

for the
purpose of decreasing aggregate demand and thus controlling
inflation.

The goal of contractionary fiscal policy is to reduce
inflation. Therefore the tools would be an decrease in government
spending and/or an increase in taxes. This would shift the AD
curve to the left decreasing inflation, but it may also cause some
unemployment.

FISCAL
POLICY

WE
ALREADY KNOW:

If
there is UE?

increase
G

decrease
T

both

If
there is IN?

decrease
G

increase
T

both

NOW WE
ARE GOING TO LEARN:

HOW MUCH Should the Government Change G or T?

So we already know that if there is unemployment the appropriate
fiscal policy would be to increase government spending and/or
decrease taxes. Here we will discuss HOW MUCH should government
spending be increased or taxes cut?

GDP

=

C

+

I

+

G

+

Xn

400

Look at the graph to the right and the formula above. You
can see that this economy is at equilibrium producing an
output of $400, but if there were full employment, a real
GDP of $500 could be achieved. Therefore, this economy has
an unemployment problem and is not producing as much as it
could. What is the appropriate fiscal policy could the
government use to move this economy to full employment?

We know that the government could increase government spending
and/or reduce taxes to increase AD and achieve full employment. Here,
let's just concentrate on government spending.

By HOW MUCH should government spending be increased to achieve and
equilibrium of $500 and full employment?

GDP

=

C

+

I

+

G

+

Xn

to ­
$100

­
?

One would think that if government spending was increased by $100
that GDP would go up by $100, BUT THIS IS NOT THE CASE! What we
are going to learn in this chapter is that a small initial increase
in spending results in a much larger change in GDP. This is
called the MULTIPLIER EFFECT. A small initial change in spending will
result in a larger change in GDP as the spending change works it way
through the economy.

How the multiplier process works:

This is because an initial change in spending will cause an
initial increase in GDP and it also becomes income to someone
else. (If I buy a new car, people who built and sold that car earn
income equal to the price of the car.) What will these people do with
their additional income? Well, they will spend some and save some.
The amount that they spend increases GDP even more AND it also
becomes income to someone else. These other people will spend some of
this additional income and save some. The amount THEY spend
increases GDP again and becomes income to someone else. This
process continues so that the TOTAL change in GDP is much larger than
the initial change in spending.

This multiplier process helps explain why cities want the
superbowl, political conventions, or the Olympics to be held in their
town. It's not just because these activities bring in people who will
spend money and create jobs, but more importantly, this initial
change in spending begins the multiplier process so that the total
economic effect and the number of jobs created is much larger than
the initial spending on these activities alone would cause.

Read this article from the Philadelphia Inquirer newspaper
(http://home.phillynews.com/gop/news/impa110698.asp).
the Republican National Convention was held in Philadelphia in 2000
and in San Diego in 1996. It is clear that civic leaders understand
the multiplier effect when they discuss "spinoff benefits".

The
Philadelphia Inquirer, November 6,
1998

Plentiful
gains seen from GOP

The
publicity for the city may be priceless. The visitors'
spending could reach $300 million.

By
Howard Goodman
INQUIRER STAFF WRITER

When
the elephants thunder into Philadelphia in 2000, the
vibrations are expected to shake an incredibly bountiful
money tree, showering dollars all over the region.
The economic impact of the Republican National Convention
will almost certainly exceed $125 million in direct
spending on hotel rooms, meals and the like, along
with at least $175 million in spinoff benefits
(emphasis added), David L. Cohen said yesterday. Cohen,
Mayor Rendell's former chief of staff, is cochairman of
Philadelphia 2000, the committee formed to woo a
political convention.
The estimate is based on a Federal Reserve Board study of
the economic blessings felt in Chicago from the 1996
Democratic convention, with a little extra figured in for
four years' worth of inflation, Cohen said.
"There is no convention you can host that has a greater
economic impact than a national political convention," he
said. "Most people agree the only thing you can host that
has a greater economic impact is the Olympics.". . . . .

In
San Diego, where the Republicans last met, business
leaders still bask in the 1996 convention's glow. "We
look at the convention as a weeklong television
commercial for your city as a destination," Salvatore
Giametta, a spokesman for the San Diego Convention and
Visitors Bureau, said in an interview this
summer.

.
. . . .

According
to the Greater San Diego Area Chamber of Commerce, the
four-day convention attracted 30,000 visitors who spent
$26 million on hotel rooms. But there has been no
follow-up study to show the convention's broader effect
on the San Diego economy.
Despite the lack of data, San Diego "absolutely" would
host a convention again, Giametta said. "We think it was
good for the tourism industry without a doubt."
Brian Ford, an accountant for Philadelphia 2000, said
that insisting on a study to prove that Philadelphia will
benefit mightily from the GOP meeting "is like saying you
need a study to show that a car works."

Above we said that the multiplier works "because an initial
change in spending will cause an initial increase in
GDP and it also becomes income to someone else. (If I buy
a new car, people who built and sold that car earn income equal to
the price of the car.) What will these people do with their
additional income? Well, they will spend some and save some.
The amount that they spend increases GDP even
more AND it also becomes income to someone else." This
process then goes on and on . . . but why does it eventually stop or
does it go on forever? If you reread the explanation of the
multiplier process above you will get a clue as to why the process
eventually stops. Notice that we said "What will these people do
with their new income? Well, they will spend some and save
some." People do not spend 100% of any additional income that
they receive. the spend some and SAVE SOME. So that the additional
spending is less than their increase in income. And when this
additional spending becomes income to someone else, they sill save
some and spend even a smaller amount. This will continue until the
total change in savings is equal to the initial increase in spending.
When this occurs there is nothing left to spend and the process
stops.

To understand the multiplier process we must gain a better
understanding of how consumption and saving respond to changes in
income. the table below is for a hypothetical economy. All values are
in $ billions.

GDP
(income)

C

S

APC

APS

MPC

MPS

$ 0

$ 40

100

120

200

200

300

280

400

360

500

440

As expected as the economy's GDP (income) increases, household
consumption increases. GDP and consumption are directly related. If
we graphed this consumption data we would get:

Notice that when income is equal to $ 0, there is still some
consumption ($ 40 billion). this is called "autonomous consumption".
It is consumption that is not related to income. Think about what a
GDP of $ 0 represents. If GDP, or an economy's income, were equal to
$0, this means that nothing was produced in this. If an economy does
not produce a thing, would there still be some consumption? Yes, but
how? they would consume goods that were saved from earlier periods.
Of course, a GDP of $0 is a ridiculous concept, but there are two
components to household consumption: (1) autonomous consumption that
is not related to income, and (2) induced consumption or consumption
that is directly related to income.

Now, to understand,a and calculate, the multiplier, we need to
complete the table.

First we need some simplifying assumptions to make our model
easier to understand:

For now let's ignore government (no government spending and no
taxes)

Let's also ignore the foreign sector (no exports or
imports)

This leaves us with an economy of only businesses and consumers,
so:

GDP

=

C

+

I

And let's assume that there is no inflation, equilibrium in
this economy occurs in the horizontal, or Keynesian, range of the
AS curve.

Given these assumptions we can calculate savings (S). With these
assumptions there are only two things that consumers can do with
their income, spend it (C) or save it (S). So:

income

=

C

+

S

Therefore, we can calculate savings:

GDP
(income)

C

S

APC

APS

MPC

MPS

$ 0

$ 40

$ - 40

100

120

- 20

200

200

0

300

280

20

400

360

40

500

440

60

Notice that savings is directly related to income. When income
increases both consumption and savings increase.

Average Propensity to Consume (APC) and Average
Propensity to Save (APS)

With this data we can calculate the APC and APS for each level of
income.

APC is the fraction of the economy's total income that is spent
(consumed) and APS is the fraction of total income that is saved.

C

APC =

--------

income

S

APS =

--------

income

When we calculate APC and APS we get:

GDP
(income)

C

S

APC

APS

MPC

MPS

$ 0

$ 40

$
- 40

---

---

---

---

100

120

- 20

1.2

- 0.2

200

200

0

1.0

0

300

280

20

0.93

.07

400

360

40

0.90

.10

500

440

60

0.88

.12

Notice that for each level of income: APC + APS = 1. Given our
assumptions there are only two things that consumers can do with
their income spend it or save it. If you add the fraction of the
total income that is spent (APC) and the fraction of the total income
that is saved (APS) we get all of our income, or 1.

Can you think of anything else that we can do with our income
besides spend it or save it? Many students will answer "invest it".
But what does investment mean in economics? Investment is the
accumulation of capital. "Capital" is a manufactured resource.
Therefore, "investment" occurs when a carpenter buys a hammer or if
McDonald's builds a new restaurant. Putting money into the stock
market is NOT investment, it is savings.

To understand the multiplier effect we need to know what happens
to ADDITIONAL, or MARGINAL, income.

Earlier we explained that the multiplier works "because an
initial change in spending will cause an initial increase in GDP and
it also becomes income to someone else. (If I buy a new car, people
who built and sold that car earn income equal to the price of the
car.) What will these people do with their
additional income?

With our consumption and savings data we can calculate the MPC and
MPS for each level of income.

MPC is the fraction of the economy's additional income that is
spent (consumed) and APS is the fraction of additional income that is
saved.

"Marginal" means "additional" or "extra"

change in C

MPC =

-----------------

change in income

change in S

MPS =

-----------------

change in income

To calculate MPC and MPS select two levels of GDP or income. for
example if income increases from $0 to $100, then consumption
increases from $40 to 120. Therefore if income increases from $0 to
$100 then the change in income is $100 and the change in consumption
is $80. MPC is then equal to 0.8.

change in C

80

MPC =

---------------

=

------

=

0.8

change in income

100

If we do this again for income level of $ 00 and $200 and
consumption levels of $120 and $200 we will get MPC = 0.8 again.

If you do the same thing for MPS you will get MPS = 0.2.

GDP
(income)

C

S

APC

APS

MPC

MPS

$ 0

$ 40

$
- 40

---

---

---

---

100

120

- 20

1.2

- 0.2

0.8

0.2

200

200

0

1.0

0

0.8

0.2

300

280

20

0.93

.07

0.8

0.2

400

360

40

0.90

.10

0.8

0.2

500

440

60

0.88

.12

0.8

0.2

Notice that for each level of income, MPC + MPS = 1. There are
two things that you can do with additional income: spend a fraction
(MPC) and save a fraction (MPS). If you add these fractions together
you will get 1.

If you remember your 8th grade math you would recognize that our
formula for MPC is actually the slope of the consumption graph.

change in C

rise

MPC =

---------------

=

------

=

slope of C

change in income

run

change in C

rise

MPC =

---------------

=

------

change in income

run

80

MPC =

---------------

=

0.8

100

And the same is true for MPS:

change in S

rise

MPS =

---------------

=

------

change in income

run

20

MPS=

---------------

=

0.2

100

One last item needs to be discussed: are MPC and MPS really
constant? Note that in our table MPS equals 0.8 for all income levels
and MPS equals 0.2. This means that if you get a raise (or additional
income) of $1000 you would spend $800 of the raise (0.8 x 1000 =
$800) and you would save $200 of it (0.2 x $1000 = $200). But is the
fraction of additional income that is spent and saved really constant
for all levels of income?

Let's assume that I am going to give two families $10,000 in
additional income. So I go to the housing projects in Chicago and
find a poor family and give them $10,000 and I fly to the state of
Washington and find Bill Gates (probably the richest person in the
world) and give him $10,000. Would they both spend and save the same
fraction of this additional income?

No, the poor family would most likely spend the whole $10,000 and
Bill Gates would probably spend nothing of the addition income. So
the MPC of the poor family would be very high, or equal to 1, and the
MPC of Bill Gates would be very low, or equal to 0. So as GDP or
income increases, MPC should get smaller, or decrease, and MPS
increases. This means the slope of the consumption graph should get
smaller (flattens out) as GDP increases.

We will assume that the MPC is constant in this course. that way
we can use straight line consumption graphs and we can find the MPC
by finding its slope.

How Does the Multiplier Work: A Numerical Example

Given our simplifying assumptions we have an economy with only
consumers and businesses. Therefore:

GDP

=

C

+

I

Now let's assume that in this economy (let's say that it
represents the Chicago area) a new stadium worth $20 million is
built. What is the total impact of this investment on the
economy?

Well, if GDP is the total market value of all final goods and
services produced in an economy in one year , then building this $20
million stadium will increase GDP initially by $20.

GDP = Income

=

C

+

I

+ 20

+ 20

But when $20 is spent (and therefore $20 is produced) $20 is also
earned as income to those who did the producing. so income also
increases by $20. What do these people do with this additional
income? Well, they spend a part and save a part. How much do they
spend and save? What concept tells us the change in consumption that
results from additional income? . . MPC !

change in C

MPC =

---------------

change in income

Let's use the MPC that we calculated above, so MPC = 0.8

So if incomes go up by $20, consumption will increase by $16
Change in C = (MPC) x (change in income)
Change in C = (0.8) x ($20) = $16

And GDP has gone up by an additional $16, but so has income. What
will they do with this income? They will spend 80% (MPC=0.8) of it
and save 20% (MPS=0.2).

So we get the following:

GDP = Income

=

C

+

I

--------

S

+ 20

+ 20

+ 16

+16

+ 4

+ 12.8

+ 12.8

+ 3.2

And GDP has increased by $12.8 and so has income, part of which
will be spent and part saved. So consumption and GDP increase by
$10.24 (0.8 x 12.8) and saving increases by 2.56 (0.2 x 12.8).

GDP = Income

=

C

+

I

--------

S

+ 20

+ 20

+ 16

+16

+ 4

+ 12.8

+ 12.8

+ 3.2

+ 10.24

+ 10.24

+ 2.56

This process will go on and on. When will it stop? If we add up
all that has been saved and it equals 20, ( 4 + 3.2 + 2.56 +
...+...+...+...= 20) then there is nothing left to spend and the
process stops. If you do this you will get the following total
changes:

GDP = Income

=

C

+

I

--------

S

+ 20

+ 20

+ 16

+16

+ 4

+ 12.8

+ 12.8

+ 3.2

+ 10.24

+ 10.24

+ 2.56

total change

total change

total change

total change

+ 100

+ 80

+ 20

+ 20

So with an initial increase in spending of $20, GDP increases by
$100.

We know that a small initial change in spending will result in a
multiplied effect on total spending in the economy, or:

change in GDP

=

initial change in spending

x

multiplier

So to answer question # 5 above we have:

change in GDP

=

initial change in spending

x

multiplier

+ $100

=

increase G by
?

x

?

If we knew what the multiplier was, we could easily calculate the
change in government spending needed to increase GDP by $100 and
achieve full employment.

1

1

multiplier =

--------

or

----------

MPS

1 - MPC

So:

1

1

multiplier =

--------

=

----------

=

5

MPS

0.2

And:

change in GDP

=

initial change in spending

x

multiplier

+ $100

=

increase G by
?

x

5

and the increase in government spending needed to increase GDP by
$100, and therefore achieve full employment, is $20.

change in GDP

=

initial change in spending

x

multiplier

+ $100

=

increase G by
20

x

5

+ $100

=

20

x

5

The Multiplier and Marginal Propensities

Notice that the size of the multiplier is inversely related to the
size of the MPS. If the MPS is larger, the multiplier is smaller.
This should make sense to you if you recall how the multiplier works.
We said: "an initial change in spending will cause an initial
increase in GDP and it also becomes income to someone else. (If I buy
a new car, people who built and sold that car earn income equal to
the price of the car.) What will these people do with their
additional income? Well, they will spend some and save
some.The amount that they spend increases GDP
even more AND it also becomes income to someone else."
So. if the MPS is larger (and the MPC is smaller) then the amount of
additional income that is spent will be smaller and this will cause a
smaller increase in GDP and a smaller increase in income to somebody
else. Any time that more is saved and less is spent, GDP goes up by
less.

You may want to try different MPC's and MPS's and see if this is
true using the formulas below:

1

1

multiplier =

--------

or

----------

MPS

1 - MPC

The Multiplier Graphically

How does the multiplier effect look on our AS-AD graph? Here is
our initial graph:

When spending (G) initially increases by $20 AD shifts to
the right $20.

Then income increases by $20 and we get $16 in induced
consumption.

This increases income by an additional $16 which increase
induced consumption by $12.8 and so on until savings equals
$20 and there is nothing left to spend. The total change in
GDP equals $100. this is the initial $20 in government
spending and a total of $80 in induced consumption.

Review of Important Formulas

change in C

MPC =

-----------------

change in income

change in S

MPS =

-----------------

change in income

change in GDP

=

(initial change in spending)

x

(multiplier)

This is the central goal of this lesson. This is the
concept that we are trying to understand!

1

1

multiplier =

--------

or

----------

MPS

1 - MPC

The Lump-Sum Tax Multiplier

There are three fiscal policy tools:

change government spending (G)

change taxes (T)

a balanced budget change which is changing both government
spending and taxes by the same amount and in the same direction
(BB)

Here, let's use the same data that we have been using to see by
HOW MUCH taxes should be changed when using fiscal policy.

Use these graphs to answer the questions that follow

Our goal is to learn by HOW MUCH the government should change taxes
to achieve full employment. We know from our AD-AS lesson that if
taxes are decreased this increases consumption and increases AD. Our
question here is if we want to achieve the full employment level of
GDP in the economy illustrated in the graphs above (full employment
GDP = $500), by HOW MUCH should taxes be cut?

What is the MPC? ______________

What is the MPS? ______________

What is the current equilibrium level of output in this
economy? ______________

What level of output can be achieved if this economy had full
employment? _____________

ANSWERS:1.
0.82.
0.23.
$4004.
$500

What change in taxes is needed to achieve full
employment?
NOW WE ARE READY TO LEARN THE ANSWER TO THIS IMPORTANT
QUESTION.

We know that a small initial change in spending will result in a
multiplied effect on total spending in the economy, or:

change in GDP

=

change in taxes

x

lump-sum tax multiplier

So to answer question # 5 above we have:

change in GDP

=

change in taxes

x

lump-sum tax multiplier

+ $100

=

decrease T by
?

x

?

If we knew what the lump-sum tax multiplier was, we could easily
calculate the change in taxes needed to increase GDP by $100 and
achieve full employment.

First, what is a "lump-sum tax"?

To make things easier for us we will discuss "lump-sum taxes"
rather then the much more common income tax. A lump-sum tax is a "tax
per person" and it does not change with income. for example if the
lump-sum tax was $500 per person I would have to pay $2000 for my
family of four regardless of my income.

Next, we know that if taxes are cut, this will increase disposable
income and therefore increase consumption:

T
ÞDI
Þ C Þ
AD

The question we have here is HOW MUCH? Let's say they decrease
taxes by $25. this then will increase disposable income (spendable
income) by $25. If consumers have an additional $25 to spend
consumption will go up by how much?

T
by $25 ÞDI by $25 Þ
C by HOW MUCH? Þ
AD

What tells us the change in consumption that results from a change
in income? . . . MPC!!!
If MPC = 0.8 then if disposable income increases by $25, consumption
will increase by $20

change in consumption = (MPC) x (change in income)

change in consumption = (0.8) x ($25)

change in consumption = $20

So what happens to GDP with the multiplier effect?

change in GDP

=

(initial change in spending)

x

(multiplier)

?

=

+ $20

x

5

So when we cut taxes by $25, GDP increased by $100. What is the
lump-sum tax multiplier?

change in GDP

=

change in taxes

x

lump-sum tax multiplier

+ $100

=

decrease T by
$25

x

?

+ $100

=

decrease T by
$25

x

- 4

So the lump sum tax multiplier is equal to -4.

There are two ways to calculate the lump-sum tax multiplier:

- MPC

lump-sum tax multiplier

=

--------------

MPS

- 0.8

lump-sum tax multiplier

=

--------------

=

- 4

0.2

and

The lump-sum tax multiplier is always negative and
ONE LESS THAN THE SIMPLE MULTIPLIER.

So in this example our simple multiplier is:

1

1

multiplier =

--------

=

--------

=

4

MPS

0.8

So the lump-sum tax multiplier is -4.

Fiscal Policy and the Balanced Budget Multiplier

There are three fiscal policy tools:

change government spending (G)

change taxes (T)

a balanced budget change which is changing both government
spending and taxes by the same amount and in the same direction
(BB)

What happens if the government changes BOTH government spending
AND taxes by the SAME AMOUNT And in the SAME DIRECTION?

We call this a "balanced-budget change". IT DOES NOT BALANCE THE
FEDERAL BUDGET, but it doesn't make it any more unbalanced. If there
is high unemployment and the government uses expasionary fiscal
policy to try to reduce the unemployment they would increase
government spending and/or decrease taxes. If they do this, spending
goes up and tax revenues go down so this would lean to a budget
deficit where they are spending more than they take in as taxes. Many
people do not what the government to deficit spend.

So let's go back to our example and see what the government can do
to reduce unemployment without creating a (larger) deficit. Use these
graphs to answer the questions that follow.

Our goal is to learn by HOW MUCH the government should change taxes
to achieve full employment. We know from our AD-AS lesson that if
taxes are decreased this increases consumption and increases AD. Our
question here is if we want to achieve the full employment level of
GDP in the economy illustrated in the graphs above (full employment
GDP = $500), by HOW MUCH should taxes be cut?

What is the MPC? ______________

What is the MPS? ______________

What is the current equilibrium level of output in this
economy? ______________

What level of output can be achieved if this economy had full
employment? _____________

ANSWERS:1.
0.82.
0.23.
$4004.
$500

What balanced-budget change is needed to achieve full
employment?
NOW WE ARE READY TO LEARN THE ANSWER TO THIS IMPORTANT
QUESTION.

So let's go back to our example and see what the government can do
to reduce unemployment without creating a (larger) deficit. What
balanced-budget change (changing both government spending and taxes
by the same amount and in the same direction) could the government
undertake to increase GDP in this economy by $100 and thereby achieve
full employment?

change in GDP

=

(balanced-budget change in spending)

x

(balanced-budget multiplier)

+ $100

=

(change G and T by
?)

x

?

What would happen if we increase G by $100 AND increase T by $100?
If we increase G, this will increase GDP, but if we increase T, this
will decrease GDP. If we do both, what happens?

.

.

.

It depends on HOW MUCH GDP changes.

So lets increase G and T both by $100. What happens?

Increase G by $100:

change in GDP

=

(initial change in spending)

x

(multiplier)

+ $500

=

increase G by
100

x

5

RESULT: GDP goes up by $500

Increase T by $100:

change in GDP

=

change in taxes

x

lump-sum tax multiplier

-
$400

=

increase T by
$100

x

-4

RESULT: GDP goes down by $400

Back to our example: What balanced-budget change (changing both
government spending and taxes by the same amount and in the same
direction) could the government undertake to increase GDP in this
economy by $100 and thereby achieve full employment?

So, if the government does both, GDP will go up by $500 and down
by $400 for a net change of
+ $100.

What is the balanced-budget multiplier?

change in GDP

=

(balanced-budget change in spending)

x

(balanced-budget multiplier)

+ $100

=

(change G and T by
$100)

x

?

+ $100

=

x

1

The balanced-budget multiplier is always a 1. This is because
the lump-sum tax multiplier is always one less than the simple (or
government spending) multiplier.

The Multiplier with Changes in the Price Level

We have been assuming that the price level does not change as AD
increases (see graph).

But in the real world as GDP increases and approaches the full
employment level of output the price level will begin to rise and
resource costs increase.

How does this inflation, which results from an increase in AD,
affect the size of the multiplier? Or, what happens to the change in
government spending needed to achieve full employment if we allow for
inflation? Without inflation, and with an MPC of 0.8, if we increase
government spending by $20 then GDP will increase by $100. the
multiplier is 4. This will shift AD from AD1 to AD2 in both graphs
above. In graph (a) without inflation the equilibrium GDP increases
from $400 to $500. But in graph (b) with inflation the same
horizontal shift in AD increases GDP from $400 to only $460. From the
same change in government spending ($20) GDP increases a small
amount. the multiplier is smaller.

To calculate the multiplier with changes in the price level you
need to know the initial change in spending ($20 in our example) and
the resulting total change in GDP ($60 from graph b above).

change in GDP

=

initial change in spending

x

multiplier

+ $60

=

+ $20

x

?

+ $60

=

+ $20

x

3

The Complex Multiplier

We have learned that in our simple model with no government, no
inflation, and no foreign sector that the size of the multiplier is
directly related to the MPC and inversely related to the MPS. In our
simple model there are only two things that can be done with
additional income: it can be spent or saved. the more that is NOT
SPENT (saved) the smaller the change in GDP that results form a
change in spending (i.e. the smaller the multiplier).

But in the real world there are more things to do with additional
income than just spend it or SAVE it. You could also give it to the
government as TAXES or spend it on IMPORTS. These last three are
LEAKAGES from the income-expenditure stream which means they are
income that we don't spend on our GDP so they don't generate
additional income and contribute to the multiplier.

DI

C

AD

Leakages

Injections

S

I

T

G

M

X

With more leakages, less additional spending is generated from an
initial injection of spending, so the multiplier is smaller.

SIMPLE MULTIPLIER

1

simple multiplier =

--------

MPS

COMPLEX MULTIPLIER

1

complex multiplier =

-------------

MPS + MPT + MPM

where MPS is the marginal propensity to save or the fraction
of additional income that is saved

and MPT is the "marginal propensity to tax" or the fraction
of additional income that is given to the government as taxes -
this is very actually the marginal income tax rate

and MPM is the "marginal propensity to import" or the
fraction of additional income that leaves the economy because
it is spent on imports.

So in the real world there are more leakages from the
income-expenditure stream and therefore the multiplier in the
real-world is smaller than the simple multiplier that we will use
most often in this class.

Discretionary Fiscal Policy (pp. 244-248)

Outline:

Financing Deficits and the Multiplier

1. borrowing
2. money creation

Debt Retirement and the Multiplier

1. debt retirement
2. impounding

Definition: Discretionary Fiscal
Policy

A deliberate changes
in taxes (tax rates) and government spending by Congress to promote
full-employment price stability and economic growth.

how the government finances
this deficit affect the size of the multiplier and the
effectiveness of FP

1. borrowing

If the government borrows to finance the deficit it may
causes crowding out

Crowding-out
Effect: A rise in interest rates caused by the Federal
governments increased borrowing in the money market
and a resulting decrease in planned investment.

multiplier
will be smaller

2. money
creation

If the Federal Reserve increases the MS at the same
time:
(i.e. uses both expansionary FP and expansionary MP)

This will keep interest
rates down and reduce crowding out so closer to the simple
multiplier

C. Contractionary Fiscal
Policy: Debt Retirement and the Multiplier

contractionary FP leads to
a greater government budget surpluses

how the government uses
these surpluses affects the size of the multiplier and the
effectiveness of FP

1. debt
retirement

If the government uses the surpluses to pay off some of
its debt, this would cause interests rates to fall and
increase AD

But the purpose of the contractionary FP was to fight
inflation by decreasing AD

So debt retirement would make the contractionary FP less
effective

a smaller multiplier

2. impounding

If the governments impounds the surpluses - just
keeps them

then the contractionary FP will be more effective

the multiplier will be closer to the simple
multiplier

Non-discretionary Fiscal Policy: Built-in Stabilizers (pp.
248-253)

Outline:

What if the economy enters a recession and
the government does NOTHING?

Taxes are directly related to GDP (income) and
Transfer Payments are indirectly related to GDP

Built-in Stabilizer

Tax Progressivity

Full-Employment Budget

A. When the economy enters a
recession the government could:

use expansionary FP
(discretionary FP)

do NOTHING
(nondiscretionary FP)

B. What if the economy enters a
recession and the government does NOTHING what
happens?

If Taxes are directly
related to GDP (income),

and Transfer Payments
(welfare) are indirectly related to GDP,

what happens to AD after
entering a recession?

taxes
decrease

government spending on
welfare

so AD increases even
though the government did nothing

C. Built-in
Stabilizer

A
mechanism which increases governments budget deficit (or
reduces its surplus) during a recession and increases
governments budget surplus (or reduces its deficit)
during inflation without any action by policy makers;

the tax system
is one such mechanism.

D. Tax
Progressivity

A tax
system wherein the average tax rate (tax revenue/GDP) rises
with GDP.

The more
progressive the tax system, the greater the economy's built-in
stability.

E. Full-Employment
Budget

What happens to the government budget deficit if it
uses expansionary FP?

What happens to the government budget deficit if the economy
enters a recession and the government does NOTHING?

So, if the government budget deficit increases when the
economy enters a recession, does this indicate that the
government is doing some SOMETHING (expansionary FP)?

Since deficits increase during recessions whether the
government does SOMETHING or NOTHING we cannot use larger
deficits as an indicator that the government is doing
something.

Therefore,
economists have created a the concept of a "full employment
budget"

An increase in the full employment budget deficit
is an indicator of discretionary expansionary FP

- actual
budget

A
listing of amounts spent by the Federal government (to
purchase goods and services and for transfer payments) and
the amounts of tax revenue collected by it in any (fiscal)
year.

- cyclical
deficit

A
Federal budget deficit which is caused by a recession and
the consequent decline in tax revenues.

The
extent to which the Federal governments expenditures
exceed its tax revenues when the economy is at full
employment (or the extent to which its current expenditures
exceed the projected tax revenues which would accrue if the
economy were at full employment); also known as a
full-employment budget deficit.

Problems, Criticisms, and Complications (pp. 253-256)

Outline

Problems of Timing

1. recognition lag
2. administrative lag
3. operational lag

Political Problems

1. other goals
2. state and local finance
3. expansionary bias
4. a political business cycle?

Crowding Out Effect

Fiscal Policy
multiplier with inflation

A. Problems of
Timing

1. RECOGNITION LAG is
the elapsed time between the beginning of recession or
inflation and awareness of this occurrence.

2. ADMINISTRATIVE LAG is the
difficulty in changing policy once the problem has been
recognized.

3. OPERATIONAL LAG is the
time elapsed between change in policy and its impact on the
economy.

B. Political
Considerations:Government has other goals besides economic stability, and
these may conflict with stabilization policy.

1. A political
business cycle may destabilize the economy:

Election years have
been characterized by more expansionary policies regardless
of economic conditions. Some call this a political business
cycle:

The alleged
tendency of Congress to destabilize the economy by reducing
taxes and increasing government expenditures before
elections and to raise taxes and lower expenditures after
elections.

2. State and local finance
policies may offset federal stabilization policies.

They are often
procyclical, because balanced-budget requirements cause
states and local governments to raise taxes in a recession
or cut spending making the recession possibly worse.

In an inflationary period,
they may increase spending or cut taxes as their budgets
head for surplus.